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Pension Plan Risk Management

Phil Kivarkis, FSA, EA, CFA, Director of Investment Policy Services

Hewitt EnnisKnupp

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Pension Funded Status – A Wild Ride

2008 Credit Crisis

US Debt Rating Downgrade

S&P 500 aggregate pension funded status shows considerable volatility, and two extreme events in three years

3

U.S. Equities Global Equities Bonds Alternatives Buy ProtectionAgainst Equity

Downside

Dynamic AssetAllocationStrategy

Our Survey Shows Broad Risk Management Focus

What changes have you made to your target investment strategy?

Source – Aon Hewitt Pension Risk Survey

38%

58%

4%

13%

68%

20%

65%

31%

10%

69%

21%

84%

14%

78%

21%

■ Reduce

■ No Change

■ Increase

3% 2% 0%

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Integrated Risk Management Toolkit

Glide Path Hedge path Credit path Return-seeking

portfolio Hedging portfolio Synthetics/Collars

FundingStrategy

Assumptionsand Methods

InvestmentPolicy

PlanDesign

Risk Management

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Pre-funding Borrow to fund Fund equity Stabilizer

Close Freeze Cash Balance/

Career Average Lump Sums

Asset smoothing Rate averaging Conservatism Aggressiveness

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Current Interest Rate Environment is Challenging

Source: Citigroup Pension Discount Curve

Maturity

Yields are below historic levels…

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Some Opportunities Exist

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Feb

-77

Feb

-79

Feb

-81

Feb

-83

Feb

-85

Feb

-87

Feb

-89

Feb

-91

Feb

-93

Feb

-95

Feb

-97

Feb

-99

Feb

-01

Feb

-03

Feb

-05

Feb

-07

Feb

-09

Feb

-11

U.S. 30Y CMT less 2Y CMT

CMT = Constant Maturity Treasury

Very steep yield curve…

Favorable credit spreads…

Source: Barclays Capital

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Pension Plans Have Already Begun to De-RiskAs Seen in Actual Allocations

Note: S&P 500, US plans only. Source: Goldman Sachs Global Markets Institute; Capital IQ; company reports.

5963

6463 62

56

45 4845

3127 28 28 28

32

41

35

35

6 6 5 6 68 9

14 16

4 4 3 3 4 4 53

4

0

10

20

30

40

50

60

70

2002 2003 2004 2005 2006 2007 2008 2009 2010(P)

In p

erce

nt

Equity

Debt

Other

Real Estate

Targets at 2010 year-end:Equity: 44%Debt: 36%Other: 14%Real Estate: 6%

Funded % 84% 90% 92% 101% 108% 79%93% 82% 86%

Stable allocation to equities took a sharp step down in 2007 despite rising share prices at that time.

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Dynamic Investment Policy Components

Glide Path Dynamic

0

10

20

30

40

50

60

70

80

90

100

Funded Ratio

As

se

t A

llo

ca

tio

n,

%

Liability Matching Rebalancing Tolerance Return seeking Glide Path

Liability Matching

Return Seeking

Current State

End State

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Probability of Outperforming Liabilities Over Three-Year Time Horizon

60%

64%

67%

69%

54%

56%

58%

60%

62%

64%

66%

68%

70%

Typical Return-Seeking Portfolio

Diversify Globally IncreasedActive/Credit Risk

Add Alternatives

Improving Your Odds

Source: Hewitt EnnisKnupp capital markets expectations

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Why Customize?

Long Gov't / Credit

Core Bonds

Custom MandateLiabilities

0%

1%

2%

3%

4%

5%

6%

7%

0% 2% 4% 6% 8% 10%

Surplus Risk

Yie

ld t

o W

ors

t

More Effective HedgeStructural

Surplus Risk

Source: Hewitt EnnisKnupp

Illustrative Example

Improved Performance and More Effective Risk Management.

Custom MandateLong Credit – 80%

STRIPS 20+ yrs – 20%

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Alternative to Immediate Extension: Two-Dimensional Glide Paths

Funded Ratio

ReturnNeeds

Return-SeekingAllocation

Hedge RatioInterest

Rate LevelDesiredDuration

First Dimension

Second Dimension

Two-Dimensional Glide Paths offer a way to manage a pension plan out of the current low interest rate environment.

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0%

20%

40%

60%

80%

100%

120%

80% 85% 90% 95% 100%

Funded Ratio

Hed

ge

Rat

io

Glide Path Implied

Liability Hedging Path Design

The glide path implies a certain liability hedging path…

Glide Path Hedge Ratio

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0%

20%

40%

60%

80%

100%

120%

80% 85% 90% 95% 100%

Funded Ratio

Hed

ge

Rat

io

Ceiling Glide Path Hedge Ratio Floor

Liability Hedging Path Design: Hedge Path Corridor

Max Rewarded Upside from Rising Rates

Max Hedge Ratio Using Physical Bonds

…but liabilities and interest rate views also imply certain liability hedging possibilities.

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Integration of Hedge Path and the Glide Path - Illustrative

  Funded Ratio 80% 85% 90% 95% 100%

Discount Rate Level LHP % 53% 67% 79% 90% 100%

Significantly High (+200 bps) 72% 86% 95% 100% 100%

High (+100 bps) 58% 72% 83% 93% 100%

Fair Value 43% 57% 71% 85% 100%

Moderately Low (-50 bps) 35% 48% 65% 82% 100%

Low (-100 bps) 27% 38% 59% 80% 100%

Very Low (-150 bps) 19% 29% 53% 77% 100%

Significantly Low (-200 bps) 18% 24% 47% 74% 100%

Key Characteristics • Tailored to Plan glide path and funded ratio goals• Incorporates Client’s interest rate views (and ours)• Provides guidance while leaving flexibility to execute

• Market opportunities (medium term views)• Available instruments

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Hedge Path Development Steps

Design Glide Path (if one doesn’t exist already)

Review Risk Budget and Investment Horizon

Develop a Hedge Path to Complement Glide Path

Develop an Execution Strategy– Update Investment Policy Statement– Consider Outsourcing Execution– Update Reporting to Include Hedge Path

Transition the Portfolio to Target Hedge Ratio on Hedge Path– Credit vs Government– Yield Curve Positioning– Use of Physicals and Synthetics

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Key Takeaways

Current Environment

Duration Extension

Customized Portfolios

Steep curve, spreads favorable Asset return risk meaningful De-risking and defeasance trends persist

Two-dimensional paths provide framework for change

Ultimately, risk management drives hedge ratio

Customization can improve hedging characteristics Relative importance increases with hedge ratio Diversification improves odds of success